Basics of Leasing By Vinod Kothari
Equipment leasing World-over has developed as one of the most potent alternatives to funding an equipment. This is intended to be a primer to understanding the business of equipment leasing. The basic features of this write-up are:
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It is authentic - written by one of the most respected leasing commentators in the World. It is independent - since the author does not have any interest in leasing business other than as trainer-author-consultant, you may expect a completely unbiased treatise. It is very simple and to-the-point. It tries to make full use of the navigational and graphical possibilities offered by the Web for cross-references, details and illustrations. It is excellent value for the time you spend reading, if you have any interest in leasing as lessor, lessee, consultant, academician or accountant.
Leasing: Alternative to funding or alternative to acquisition?: Is leasing merely an alternative to funding, or is it an alternative way of acquiring the equipment? If it were a pure financial alternative, the user should stay in the position of a virtual borrower. In other words, the user can look at leasing as a mode of financing - just as loan, bond or other borrowing option. If it were an alternative mode of acquiring an asset, such as an asset-renting option, it becomes a distinctive way of getting to use an asset without owning, or almost-owning it. In this case, the user would be looking at leasing as an alternative mode of acquiring the equipment, significantly different from a plain financing alternative. If a lease plan is a funding alternative, it is called a financial lease. If it is not a financial alternative alone, it is an operating lease. Most lessors are financial intermediaries, and therefore, are obviously comfortable with financial leases. Most leasing in the World is still financial leasing. However, operating lease plans are also available for many equipments now. Operating leasing is certainly a faster growing segment of leasing business.
. not to you As long as you are able to milk the cow. from a supplier identified by you. In a loan. Yes. I am saddled The lease will be non-cancellable till the lessor with the asset for long. In a loan. you can look at the rentals as being composite interest and principal. Except that they are not worded as such. I would buy exactly the asset I need. the payments by the lessee will be in form of lease rentals. I repay the loan and pay some interest on Mostly. How different is the charge in case of return the lessor's investment. assets acquired with a loan are you to exhaust most of the asset value . and all risks on the asset will be yours. etc. In the loan case. leases carry a renewal clause also. and some return on lease? thereon. Financial leases are "loan look-alike": However. the lessor as a matter of fact purchases assets would the lessor be able to provide me exactly selected by you.
Having bought the asset with a loan. does it mean all these costs and risks will be taken by the lessor? The lessor would not take any risk in the asset at all : all costs on account of the asset will be borne by you. etc. are financings by contrivance.financial your own assets. or leasing for the purpose of financing. can I return the leased asset fully recovers his investment. obsolescence. it is available only for the The lease period is made sufficiently long to allow period of lease. If it is a leased asset. The lease document will contain elaborate clauses to this effect. it matter who owns the cow! Ownership. Let us have a look at the differences between leasing and plain financing. If I take the asset on lease. the generic differences noted above still remain. repairs. To achieve the financing purpose. the lease rentals are calculated to fully the loan. financial leases.maintenance. the leasing structure here tries to eliminate the substantive differences between leasing and plain financings.Financial leases:
Here. In other words. though being leases by structure. and see how are these sought to be eliminated in financial leases:
If you are the lessee …
These are the differences between leasing and This is how they are tackled borrowing The leased asset belongs to the lessor. all the risks and costs on the asset are mine . the purpose and effect is virtually financing financing by the device of leasing. after all. though the device used is leasing. the lessor will provide an asset and not the money needed to buy it. what I want? purely at your behest. how does as in case of loan. is primarily use-value. So you can't do in a as I feel like? lease what you can't do in a loan. However.
A will be allowed to negotiate all commercial terms with the supplier including the technical specifications. more easy in case of a lease. (This would. however. all risks on the asset matter of security.)
A typical financial lease: Take the following as an illustrative prototype of a financial lease:
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Company A wants to acquire a boiler of a particular specification. The lease is nonit mean I carry the entire obsolescence risk in it? cancellable. In a loan. the lessor will sell the asset at the prepayment value to you. as the asset belongs to you. if the asset is expected to last for more than 5 years.meaning without reference to the state or value of the asset. next 5 years at a nominal rental. the lessee could be given an option to buy the asset as a token value. What In a lease. be subject to local laws. for 60 months. the lessee will be given a convenient renewal option. I can You would do the same in a lease. you can take lease rentals as bundled repayment of principal and interest. can I prepay a lease?
Unless there are technical difficulties in doing so. I get the interest and the principal. the lessee has a right of renewal. What if the asset does not work? I am not You are not concerned in case of a lease also. perhaps a little confiscate the asset. in such case. The concerned in case of a loan. The asset would be put on lease for 60 months. till all your investment is recovered. does are absorbed by the lessee.
If you are the lessor …
In a loan. [Alternatively.000. depending on the regulations prevailing. you get the lease rentals. nay. junk.50 per month payable monthly in advance. Company B is prepared to give it on lease on lease rentals of $ 22.I can prepay a loan. B would walk in after everything is finalised: B would place its orders in the terms A instructs. for.]
. Leave apart the do I get in a lease? name. and acquire the asset. It would cost $ 100. He would to any benefit? I don't get any such benefit in a continue using the asset till it becomes an economic loan. Let us suppose the deal is to be put through. say. prepayment of a lease is allowed. if the leased asset is mine. What if the lessee doesn't pay? In a loan. rentals are payable unconditionally . What if the asset appreciates in value? Do I stand Nope. I am concerned with the asset only as a The risk of obsolescence.
The primary The first 5 years are called the primary lease period and the and secondary extended period is called the secondary lease period. the lessee will have no incentive of returning the asset. value or utility of the asset. but implicit in the rate of rentals. in the present example. As such. Full lease Incidentally. He only takes financial risks and financial rewards. and that is why the name financial leases.this is equivalent to the rate of interest in case of loans.
. meaning the lessee cannot return the asset and not pay the whole of the lessor's investment. they are full-payout. As this rate is not explicit. the lessor would get no more. In this sense. and no less. The lessor takes no asset-based risks or asset-based rewards. The lease is non-cancellable. the rate is implicit rate of return or IRR. Thus.98% . Financial leases put the lessee in the position of a virtual owner. than such pre-fixed return on investment. The IRR Features of financial leases: The above discussion leads to the following features of financial leases: Financial leases allow the asset to be virtually exhausted by the same lessee. the lessee has been put virtually in the position of an asset owner . If the lessee performs as per agreement. meaning the full repayment of the lessor's investment is assured. with a power to extend the lease period for another 5 years. irrespective of the state. the asset will be enjoyed by the lessee virtually for the whole of its economic life. As the lessor generally would not take any position other than that of a financier.he has the right to use the asset for 5 years. payout The lessor too has no significant risk/reward other than that of a virtual money-lender: he would continue getting the lease rentals for the primary period which will fully-payout the lessor's investment in the lease as also give him his desired return on investment.that is. the lease is net lease. he would not provide any services relating to the asset. For the secondary period. the lessor gets a return of 12. in the above example. whereas the asset might still carry substantial value.As you might notice. lease period The lease is non-cancellable during the primary lease period . as what the lessee has to pay is nominal. the lessee cannot return the asset and not pay balance of the lessor's rentals.
Hire-purchase and financial leases compared Hire-purchase is of British origin . etc. an option to buy the asset at a token value. at the end of the fixed term of hire. if the regulations permit. Australia. the hirer may off-hire the asset and close the contract.the device originated much before leases became popular. this option is called bargain renewal option. If such an option is embedded. performance. called secondary lease period. A hire-purchase transaction is usually defined as one where the hirer (user) has. The fixed lease rentals give rise to an ascertainable rate of return on investment. Most of these countries have enacted. New Zealand. financial leases with a bargain buyout option at the end of the term can be called a hirepurchase transaction. In other words. Financial leases are technically different but substantively similar to secured loans. or any other extraneous costs. Substance of financial lease:
. distinction is made between lease and hire-purchase transactions. Financial leases and Hire-purchase : In some countries. Alternatively. The value of the asset is important only from the viewpoint of security of the lessor's investment. called implicit rate of return. the lessee may be given a purchase option at a nominal price. the lessor's payback period. viz. primary lease period is followed by an extended period to allow exhaustion of asset value by the lessee. In financial leases. the lessor's rate of return is fixed: it is not dependant upon the asset-value. If the asset were to become obsolete during the pendency of the hire term. In financial leases. The device is still popular in Britain. hire-purchase becomes significantly different from a financial lease: the risk of obsolescence gets shifted to the hire-vendor. the hirer has to be provided with the option of returning the asset and walking out from the deal. As the renewal is at a token rental. in line with United Kingdom.The risk the lessor takes is not asset-based risk but lessee-based risk. specific laws dealing with hire-purchase transactions. India. and spread to countries which were then British dominions. but in some cases. Hire-purchase is decisively a financial lease transaction. leaving the owner with less than a full-payout.. Pakistan. called bargain buyout or purchase option. it is necessary to provide the cancellation option in hire-purchase transactions by statute: that is.
may lead to completely different implications. the lessee. doing so is not easy because it would mean going beyond the apparent form of a contract. laws. and be able to create a situation by which the substance rule fails. if financial leasing is so close to lending. There are two reasons to this . it should form a part of overall financial markets regulation most countries' central banks maintain some control on financial intermediaries. apparently a mere user of the asset. such ideal is never achieved. it should have been treated as such for every purpose. His income should be the implicit part of rentals going towards return on investment. and distinguished from loans in for some others. along with a corresponding liability to pay fixed rentals to the lessor.understandably. and the lessor should have been treated as a lender. If the lease is treated as a financing transaction. to an extent. taxed and accounted for as plain loan transactions? This question may be significant from viewpoint of :
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Regulation of financial leasing activity. the lessor is the sole owner of the asset and the lessee is merely its bailee. Asset rights of the lessor. taxation and accounting). Taxation of the lessor/lessee. or rather thrive on. financial leasing all over the World continues to live with.
In each case. treating the lease as a lease or. a financing transaction. the lease/loan treatment also depends upon the maturity of a country's regulatory system to appreciate the substance of a deal by exploding its form .
Ideally. the asset should feature on the Balance Sheet of the lessee rather than the lessor. should be treated as a virtual owner and should be allowed all asset-based benefits. while in a plain lease contract. regulators and taxmen are conditioned by the legal fabric of a transaction. And two. Therefore. Accounting for the lease transaction. and not nomenclature.
o o o From viewpoint of general regulation of financial leasing activity. So.one. However. if the lease is a mere financing arrangement.If financial leases are substantively so close to secured financing transactions. the categorical issue is: why should they be treated as a lease at all? Why should they not be regulated. differing approaches to its character . any system should be able to differentiate or integrate transactions based on their substance. there might be numerous combinations treating financial leases as loans on
. if it is taken as financing by another name. Likewise. Besides. From accounting viewpoint.it being treated at par with loans for some purposes. The asset-rights of the lessor would also be similar to those of a secured lender. based on substance. the lessor should not be allowed to claim any asset-related benefit. Based on the 4 major areas listed above (general regulation. lessors would emphasize upon on one or more structural differences between a lease and a loan. asset rights. such as depreciation.
In a financial lease. In other words. and since these assets are hired for a very short-term need. Accountings standards are the first (perhaps because they are least dependent on a statute) to realize the indifference between leases and loans. but cancellable leases
. So what is included in the "operating leasing" industry is such asset renting where the user needs the asset for long term. such rentals are highly commodity-specific.any lease other than a financial lease is operating lease. Understandably. the word "operating lease" is applied with no indication to the lessor operating the asset. any lease where lessor takes a risk other than a plain financial risk is an operating lease. these are not included in the caption "lease" at all. Taxation. mutually unrelated asset-rental activity. income-tax. it is possible to have:
Full service leases Net. but today. hiring of a car for a day.say. for enforcement of a contract.
Therefore. but is cancellable. the lease is long term. Does the name "operating" lease mean the it is the lessor who operates the leased asset? Well. moves close to accounting standards. the way the parties create their mutual rights apparently is more important than what could have been their intent behind such creation
Any lease other than a financial lease is an operating lease. he merely finances it. but he does not commit himself to any permanent usage or a very long term. General property laws are the last to do so. the lessor does not operate the asset he leases. that might have been the meaning years ago. etc. or furniture for a function at home. These hirings are done by agencies specialized in this respective hiring. particularly. and including these all as a part of the "operating lease" category would bring into fold an extremely variegated. but only a contra-distinction to financial leases.security for some purpose and true lease for some other purposes. Within this long-term but cancellable lease variety. Operating lease does not mean the lessor operates the asset . This would include a variety of lease plans with differing add-ons or leave-outs by different lessors but broadly falling into two categories:
Short term rentals Long term cancellable leases
The first category includes hiring of utility assets for short periods . because often.
A prototype operating lease: Whereas financial leases are more or less similar. they are also not financial leases as the lessor does carry a risk. and thereafter.000. because thereby the lessor can control his asset-based risks.based on the risks the lessor takes or avoids. for a non-cancellable period of 4 years. and the lease is not full payout. Such leases are not operating leases in the strict sense as they are non-cancellable in part. Let us suppose the deal is to be put through.50 per month payable monthly in advance. Most are significantly. Company B is prepared to give it on operating lease on lease rentals of $ 22. This is almost a financial lease by structure. The asset would be put on lease for 48 months non-cancellable period. but there are significant differences. however. and might be non-cancellable for a substantial part of the asset life to allow the lessor to recover a major part of his investment. Besides. during which the rental charge does not fully payout the lessor. thereafter. This is a re-statement of prototype financial lease example taken earlier. the lessee has the option to renew the lease at the same rental or to return the asset and close the lease.
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Company A wants to acquire a boiler of a particular specification. operating leases take innumerable forms . It makes good sense for the lessor to run and maintain the asset. It would cost $ 100.A full service lease will imply the lessor will run and maintain the asset. In other words.
Returns operating leases residualdependent
in This model has been drawn on the basis of the financial lease example above. B would walk in after everything is finalised: B would place its orders in the terms A instructs. but would not operational or maintenance responsibilities. cancellable at the lessee's option. but with an element of asset risk with the lessor .the lease period is partly cancellable. Hybrid operating lease are virtually financial leases. and the involvement of the lessor in operation of the asset. Such leases are common in case of cars. one possible operating lease example. Such leases can be called hybrid operating leases or hybrid financial leases. the lease is non-full payout : after paying off the
. albeit limited risk. operating leases are still in emerging form. earth-moving equipments. the lease is cancellable at the lessee's option. The following is. thereafter. and acquire the asset. All operation and maintenance will be the responsibility of the lessee. etc. A will be allowed to negotiate all commercial terms with the supplier including the technical specifications. In some cases. This is more common in case of plant and machinery. and there are no standard operating lease plans. on the asset value. the non-cancellable lease period is only 4 years. a lessor would take the risk of obsolescence by providing the cancellation option.
As a matter of fact. and yet significant risk on the value of the asset? Yes.
. this value has no significance since all the lessor would get is the pre-fixed rental. meaning the lessee can return the asset and not pay the whole of the lessor's investment. the lessor may continue to get the same rental for the 5th. Features of an operating lease: Once again. The lease is either fully cancellable or partly non-cancellable and partly cancellable.therefore. Even in case of hybrid leases.lessor over 4 years. He might make a profit or a loss in the deal depending upon the actual residual value of the asset . Is that possible? Is it possible that the lessor charges the same as in the financial lease example. the lessor carries a residuary asset-based risk. Hence.. In a hybrid lease. he may make a profit by sale of the asset at the end of 4th year. an operating lease is an investment in the value of an asset. residual value for recovery of the balance. Note one striking feature: though hypothetically. As the lessor would not have recovered the whole of his investment over the fixed period. This is based on the lessor's estimation of the residual value of the asset . the lessor is directly affected by the state and efficiency of the asset. and therefore. In a full-service operating lease. the lessor takes both financial risks and asset-based risks. However. The lessor does take asset-based risks and asset-based rewards: the extent of such risks and rewards differs based on the nature of the lease. Operating leases do not put the lessee in the position of a virtual owner: in full service rentals. the 6th and the 7th year. Or. the following is a re-statement of the features of financial leases noted earlier: Operating leases may not allow the asset to be virtually exhausted by the same lessee: a rental transaction. as an operating lease itself fails a standard definition. he depends on the value of the asset at the end of the lease period. the lessee may decide to go for an alternative equipment. the basic features that differentiate it from a financial lease are as follows. if the asset has substantial value. or in fact. the lessee is merely using the asset. allows an asset to be used by a series of users. Once again. viz. it is quite possible that the operating lease rentals may be the same. but we presumed that the rentals in the above example are the same as in case of financial lease. the lessor's returns in an operating lease carry a residual dependence.in a financial lease. lower than those of a financial lease. In the example above. the lessee does not have the same commitment to the asset he has in case of owned assets. for example. there are no standard features of operating leases. it is never possible to pre-estimate the returns from the operating lease.
the lessor may provide any services relating to the asset. Therefore. or costs relating to the asset. of course. but the value itself determines the lessor's returns. The risk the lessor takes is asset-based risk. In operating leases. and hence a lessee-based risk. meaning the full repayment of the lessor's investment is not assured by the lessee. has been propelled both by market forces (basically the need to distinguish the lease product from other financial products) as also by such regulatory tendency. or operations.com/Basics1. The value of the asset is important not only from the viewpoint of security of the lessor's investment. Operating lease. taxmen. The move towards operating leases. such as maintenance. the implicit rate of return in an operating lease is always a matter of probabilities and is uncertain. and the trend would understandably continue. In an operating lease. Move towards operating leases is partly for tax and accounting motivations Source: http://www. has been helped largely by such regulatory developments. a developing part of the leasing industry. Accounting standards in many countries have long recognized the substance of financial leases and put leased assets and liabilities on the lessee's balance sheets. In such case.In this sense. and accountants that a plain financial lease is no different from a secured lending. operating leases are non-full-payout. the lessor's rate of return is dependant upon the asset-value. there is always a dependence on the lessee's commitment to pay.html
. particular the hybrid leases. there has been a strong tendency towards equating the two. The move towards operating leases: It was noted earlier that there has been a growing awareness among regulators. performance. the lease is wet lease. Financial leases are technically as well as substantively different from secured loans. Tax laws also over years have moved from granting asset-based tax allowances to every lease to only such leases which qualify as true leases and that term would exclude a strict financial lease. Hence.india-financing. The fixed lease rentals cannot give rise to an ascertainable rate of return on investment.